(Editors' note April 16, 2014: The author has updated his views on NXST after speaking with management, leading to a material change in the author's thesis. Readers are encouraged to read the updated article here.)

Given a new Federal Communications Commission (FCC) regulation to limit joint sales agreements (JSAs) on March 31, a market-neutral pair trade opportunity has arisen in the local broadcasting sector. Following my high conviction buy/long idea on Gray Television (NYSE:GTN) (as its fundamentals are little impacted by the regulation) last week, I pick Nexstar Broadcasting (NASDAQ:NXST) as the stock to short in the market-neutral pair trade strategy. Due to the new regulation, Nexstar is on the opposite end of Gray Television, fundamental-wise.

New FCC regulation in place

To recap, on March 31, FCC issued a new order regarding joint sales agreements. In short, FCC bans JSAs between two local television stations in the same market in which a station sells 15% or more of advertising time of another station. This is because the former is considered owning/controlling the latter, which is against FCC's current ban on duopolies. Parties to existing JSAs will have two years to come into compliance. Waiver requests will be considered on a case-by-case basis if the stations can prove the strict compliance with the new rule is inconsistent with the public interest.

As a review, a local marketing agreement (LMA) which primarily consists of a JSA and/or a shared service agreement (SSA) has been used by two television stations in the same market to circumvent FCC's duopolies ban. In particular, the LMA has proliferated since 2011 due to industry consolidation (M&A). A JSA, as the word implies, is an agreement between two television stations in the same market to sell advertising time together with a revenue-sharing scheme. An SSA is an agreement in which a bigger station provides back-office and programming production to a smaller station, typically for a fee. Hence, it is clear that a JSA has an anti-competitive element, which explains FCC's motive to ban JSAs. Meanwhile, an SSA remains permitted although FCC will ask for more disclosure of the SSA terms from the stations.

Given that a JSA needs to be unwound in two years, the revenue loss will be the main negative impact to broadcasters (after the JSA is unwound). Of course, the magnitude of the revenue loss will depend on JSA sales exposure, in particular.

Worst hit

As stated earlier, as opposed to Gray Television, Nexstar will be worst hit by the new JSA rule. This is because Nexstar is one of the pioneers in using LMAs to operate as a duopoly in the same market.

In general, there are two types of stations: 1) owned-and-operated (O&O) stations, which are directly owned by Nexstar; and 2) non-owned and operated (non-O&O) stations, which are owned by a third party (primarily a company named Mission in Nexstar's case). In non-O&O stations, Nexstar earns revenue through advertising time sales (JSA revenue) and/or provision of production programming or back office operation (SSA revenue). Hence, given the new JSA rule, non-O&O stations' revenue (JSA revenue in particular) will be adversely impacted.

As of December 2013, Nexstar has 25 non-O&O stations out of a total 75 stations it operates (the other 50 are O&O stations). Its ratio of non-O&O stations to total stations (33%) is the highest among listed broadcasters. Based on respective 10-K's, as a comparison, the percentage of listed competitors is as follows: 2% (1 non-O&O out of a total 51 stations) for Gray Television, 10% (3 out of 31) for Media General (NYSE:MEG), 12% (6 out of 50) for LIN Media (NYSE:LIN), and 16% (24 out of 149) for Sinclair Broadcast (NASDAQ:SBGI).

(click to enlarge)

Specifically, based on its 2013 10-K, 77% of Nexstar's revenue comes from duopoly stations (an O&O and non-O&O station operating in the same market). Nexstar does not disclose the specific percentage of revenue attributable to JSA, in particular. In its 4Q13 earnings call, when asked about its JSA exposure, management only stated that 1) some 70% of revenue comes from duopoly markets and 2) its JSA agreements are mainly between Nexstar and primarily Mission in which Nexstar takes 30% of advertising revenue while MissionN keeps 70% when selling advertising time together. In general, management's tone became defensive, stating it would not comment on potential impact of new JSA regulation at all. This attitude was in a stark contrast to Gray Television, which stated immaterial impact.

When I personally tried to reach Nexstar investor relations via email or phone calls, there was no response/call return. As a comparison, I got a response from Gray Television (via a call return) and Sinclair Broadcast (via email), clarifying their JSA sales exposure.

Therefore, apart from publicly-available information (77% of revenue comes from duopoly stations), I don't have the specific JSA sales disclosure for Nexstar. However, having worked out the publicly-available information mathematically and done a cross check with some industry sources regarding revenue comparison between O&O and non-O&O stations, I estimate that JSA accounts for 15-17% of Nexstar's revenue.

A cross-check from competitors' information also reveals that the percentage of non-O&O stations to total stations will give good approximation of JSA & SSA sales exposure. Moreover, it is common that 50-60% of non-O&O stations' revenue is JSA while the remainder 40-50% comes from SSA. For example, Sinclair Broadcast disclosed that 10% of its revenue is JSA, which can be approximated from 60% of its percentage of non O&O stations to total stations (16%). Applying a similar approximation method, I found that my estimate of 15-17% of Nexstar's revenue as JSA revenue should be very reasonable.

High percentage of non-O&O stations in pending acquisitions

Nexstar has announced $498 million worth of acquisitions (a total of 37 stations), pending Department of Justice and FCC approval. Specifically, these consist of six transactions (see table below), with Nexstar as the acquirer of O&O stations and largely Mission as the acquirer of non O&O stations. Worth noting is that 13 out of a total 37 stations would be non O&O stations for Nexstar. Hence, Nexstar's revenue proportion (JSA & SSA revenue in non-O&O stations owned by Mission) will be consolidated into the latter's financials, which has been the accounting practice.

Assuming the acquisitions of 37 stations are approved, Nexstar would have 112 stations consisting of 74 O&O stations and 38 non-O&O stations. This implies that Nexstar's non-O&O stations as a percentage of total stations would remain at a high 33-34%, the same as its pre-acquisition level. Hence, 15-17% of Nexstar's revenue post-acquisition would likely remain exposed to JSAs.

Growth story unraveling

Given its high JSA exposure (15-17% of revenue), the big implication to Nexstar, fundamentally speaking, is that its growth story (at the EBITDA level in particular) is likely to unravel. This is because a broadcaster has majority of its operating cost as a fixed expense. Thus, my sensitivity analysis reveals that for every 1% in revenue loss, EBITDA reduction would be approximately 2%.

Moreover, replacing JSA revenue (15-17% of revenue) with more revenue from O&O stations is a tall order given that same station growth is 3-4% pa. Also, there is a limitation on prime time availability (majority of revenue for a station) given the high utilization rate.

Before I calculate the revenue loss arising from JSAs for Nexstar, I would like to highlight that, based on the new JSA rule, less than 15% of advertising time sales remains permitted. The use of the word "advertising time" leaves possibility of revenue retention of more than 15% in a JSA since prime time revenue is much higher than that of non-prime time. Hence, 15-17% JSA sales exposure would not amount to 30-34% EBITDA reduction, but less than that given possibility of revenue retention of more than 15% in a JSA. Specifically, I calculate that 30% revenue retention (70% revenue loss) in a JSA is possible, assuming that prime time ad rate is approximately 10x that of non-prime time.

Taking into account 30% of revenue retention in a JSA, Nexstar's revenue loss would be approximately 11% given 15-17% JSA sales exposure. This would translate into a 22% EBITDA reduction for Nexstar. On a consolidated financial, I put in the loss of JSA revenue for 2016-17 scenario (note that a JSA does not need to be unwound immediately, but in two years).

Net-net, my financial model forecasts average 2016-17 EBITDA of $262 mn for Nexstar. This is 8% lower than average 2014-15 EBITDA of $285 mn. Importantly, this EBITDA difference illustrates pre- and post- JSA unwinding, which reflects the theme of the unraveling growth I alluded earlier. Assuming no JSA unwinding, average 2016-17 EBITDA would be around $331 mn, 16% higher than average 2014-15 EBITDA. Note that I use average 2014-15/2016-17 to smooth out higher revenue effect in even years due to big political ad spending.

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Valuation

Here, I would delve into Nexstar's valuation/EBITDA forecast based on 1) base case: pending acquisitions are granted approval and the company would experience JSA revenue loss in 2016-17 2) pessimistic case: pending acquisitions with regards to non-O&O stations are not granted approval and the company would experience JSA revenue loss in 2016-17 and 3) optimistic case: pending acquisitions are granted approval and half of non-O&O stations get waivers from FCC so that these stations don't experience JSA revenue loss in 2016-17.

As for valuing Nexstar, I use EV/EBITDA, which is the most commonly used multiple for media companies (local broadcasting sector is a sub-sector). The broadcasting sector trades at 9.2x average 2014-15 EV/EBITDA, reflecting rising regulatory risk premium, which implies growth story concern. In December, the sector traded at 10.5x average 2014-15 EV/EBITDA, which I take as what the market is willing to pay for broadcasters with a normal regulatory risk premium (implying the growth story remains intact). Based on my observation of these two multiples, I believe 9x is the right multiple for Nexstar on the account of unraveling growth story due to a new JSA regulation. Recall that in my Gray Television's article, I use 10x multiple in its PT derivation as its growth story remains intact despite the adverse regulation. The multiple difference for Gray Television and Nexstar is justified, in my view, given the diverging growth stories.

EV/EBITDA

2014

2015

Avg 2014-15

Sinclair Broadcasting

7.1

8.4

7.8

Media General

7.6

7.9

7.7

Lin Media

9.7

11.6

10.7

Gray Television

9.5

10.8

10.1

Nexstar Broadcasting

9.6

10.2

9.9

Avg broadcasting

8.7

9.8

9.2

Moreover, given a 2-year JSA unwinding period, I use average 2016-17 EBITDA, which reflects earnings post JSA unwinding. Importantly, the average 2016-17 figure is the EBITDA the market would be interested in most following the new JSA regulation. As to why I use average 2016-17 figures, this is to smooth out higher revenue effect in even years due to big political ad spending for broadcasters.

Base case: 31% downside potential

In my base case, I assume pending acquisitions (a total 37 stations) to go through and the company would experience JSA revenue loss in 2016-17. In this scenario, the company would have 112 stations consisting of 74 O&O stations and 38 non-O&O stations. Average 2016-17 EBITDA, based on my model, would be $262 mn for Nexstar or 8% lower than average 2014-15 EBITDA. Applying 9x EV/EBITDA multiple, fair value would be $ 27.66/share or a 31% downside potential.

Fair Value Calculation

Base case

Pessimistic case

Optimistic case

Target EV/EBITDA multiple, x

9.0

9.0

9.0

Avg 2016-17 EBITDA

262

227

297

Intrinsic EV, mn $

2,361

2,047

2671.6

Investment, mn $

-

-

-

Cash & cash eq, mn $

40

40

40

Debt, mn $

1,564

1,414

1,564

Minority interest, mn $

-

-

-

Intrinsic equity value, mn $

836

673

1,147

# of shares, mn

30

30

30

Intrinsic value/share, $

27.66

22.27

37.95

Downside potential

-31%

-45%

-6%

Pessimistic case: 45% downside potential

Here, my assumptions include 1) acquisitions of 13 non-O&O stations (out of a total 37 stations) are not granted approval 2) the company would have JSA revenue loss in 2016-17. Thus, under the pessimistic case, Nexstar operates 99 stations consisting of 74 O&O stations and 25 non-O&O stations. My model subsequently yields average 2016-17 EBITDA of $227 mn or 13% lower than EBITDA in the base case. Intrinsic value is $22.27/share or 45% downside potential. In this scenario, I only assume additional $350 mn debt, instead of $500 mn debt in the base case, due to the assumption of failed non-O&O acquisitions.

Optimistic case: still a 6% downside potential

In the optimistic case, I assume 1) pending acquisitions (a total 37 stations) will materialize and 2) half of non-O&O stations obtain waivers from FCC (recall that the waivers, according to the new regulation, are considered case-by-case) so that there is no JSA revenue loss in these non-O&O stations. Average 2016-17 EBITDA would be $297 mn or 14% higher than base case EBITDA. My intrinsic value, using 9x EV/EBITDA, is $37.95/share or a still 6% downside potential. In other words, the current share price has priced in FCC waivers for more than half of Nexstar's non-O&O stations. In my opinion, this is very optimistic.

2. Some of the pending acquisitions (especially the non-O&O stations) do not obtain regulatory approval

3. Growing investors' realization that Nexstar has one of the highest JSA sales exposure among listed broadcasters

4. Diverging EBITDA growth performance between Nexstar (the one adversely impacted from new regulation) and Gray Television (immaterial impact)

5. Multiple rating downgrades by sell-side analysts (the majority of sell-side ratings - 5 out of 8 - remain a Buy now, with 2 Holds and 1 Sell, based on Bloomberg data)

Risk factors

The biggest risk factor to my short thesis is if Nexstar could obtain FCC waivers on its non-O&O stations, meaning no JSA revenue loss. FCC has stated that waivers are considered case-by-case if a broadcaster can prove that JSA is in the public interest. Hence, I would say that the next 12-24 months, Nexstar will try to provide such proofs to FCC. In my optimistic case, I try to quantify this risk factor, which is by assuming that half of non-O&O stations (19 out of a total 38 non-O&O stations) obtain FCC waivers. Under this scenario, fair value for Nexstar would be only $37.95/share, still a 6% downside potential. If all of 38 non-O&O stations obtain FCC waivers, then, of course, the growth story of Nexstar would resume. As mentioned above, average 2016-17 EBITDA without any JSA revenue loss would be $331 mn, which is 16% higher than average 2014-15 EBITDA figure. But, I view Nexstar obtaining FCC waivers on all of its non-O&O stations as clearly a blue sky scenario (highly unlikely). In the first place, had the FCC not been concerned with existing JSA practices (and their anti-competitive effect), it would not have issued a new JSA regulation.

Brief Company Description

Nexstar is a broadcasting company, focused exclusively on the acquisition, development, and operation of local television stations. The company owned, operated, programmed or provided sales and other services to 75 stations, as of Dec 2013. Specifically, it consists of 50 O&O stations and 25 non-O&O stations. Nexstar operates 50 stations as a duopoly in 25 markets. The 75 stations are broken down into 19 ABC affiliates, 16 NBC affiliates, 14 FOX affiliates, 13 CBS affiliates, 6 CW affiliates, 6 MyNetworkTV affiliates, and 1 Telemundo affiliate. Together, these stations reach 12.9% of American households. With pending acquisitions, Nexstar would add 37 stations (24 O&O and 13 non-O&O) into its portfolio. Strategy-wise, Nexstar focuses on mid-to-small size DMAs (Designated Market Areas) as management believes in lower operating cost/higher margin from these markets. In addition, the company has embarked on aggressive acquisitions, almost doubling its station count from 58 stations as of June 2012 to potentially 112 stations (if pending acquisitions are approved). Revenue breakdown is as follows: 53% local ad, 23% national ad, 20% retransmission fee, and 4% others.

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Conclusion

In my investigation, Nexstar is a broadcasting company with one of the highest JSA sales exposures (15-17% of revenue) among listed broadcasters. As a comparison, Gray Television has only 1% JSA sales exposure. Given new FCC regulation, Nexstar and Gray Television will make the perfect market-neutral pair trade, with the former as the short idea. Fundamentally, due to new JSA regulation, Nexstar's growth story is likely to unravel. Catalysts such as the company's eventual disclosure of JSA revenue exposure, some of pending acquisitions falling apart, and growing investors' realization on high JSA revenue exposure could de-rate Nexstar's share price substantially. My intrinsic value in base and pessimistic case reveals a 31-45% downside potential from current share price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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